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The Shadow Economy of Bangladesh: Size Estimation and Policy Implications
Dr. M. Kabir Hassan Professor of Economics & Finance University of New Orleans, USA
E-mail: [email protected]
Research Report conducted under a Fellowship offered by Transparency International Bangladesh
January 09, 2011
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The Shadow Economy of Bangladesh: Size Estimation and Policy Implications
Researcher Dr. M. Kabir Hassan Professor of Economics & Finance University of New Orleans, USA E-mail: [email protected]
Acknowledgements: The author thanks the research and editorial help provided by M. Zakir Hossain Khan, Geoffrey Ngene and Kathyryn Huff in completing this report. The author is grateful to TI-Bangladesh for sponsoring this study.
TIB Fellowship Programme: The study has been conducted under the TIB Fellowship programme. Detailed information about the Fellowship programme can be found in www.ti-bangladesh.org
January 2011
Copyright: @ Transparency International Bangladesh
Views expressed in this report are author’s own and may not necessarily reflect that of Transparency International Bangladesh
Transparency International Bangladesh House #141, Road #12, Block #E, Banani, Dhaka-1213 Phone: 880-2-8826036, Fax: 880-2-9884811 E-mal: [email protected] Website: www.ti-bangladesh.org
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Preface
Transparency International Bangladesh (TIB) has been working with the mission of catalyzing a sustained and effective social movement against corruption in Bangladesh. TIB’s vision is a Bangladesh where government, politics, business, civil society and lives of the common citizens would be free from corruption, and institutions of public interest would be transparent, accountable, credible and effective.
Among its manifold activities aimed at creating conditions for reducing corruption and raising demand for establishing transparent and accountable governance are research, advocacy and citizen’s engagement. A core element of TIB’s research programmes are studies conducted to identify the root causes of corruption and governance failures in selected institutions of public interest and to recommend corrective measures and policy recommendations.
This study has been conducted under the Fellowship programme of TIB, the main objective of which is to complement the in-house research capacity of TIB and facilitate greater interaction, learning and sharing of TIB with scholars, academics, researchers, lawyers, journalists and other professionals who are not directly involved with anti-corruption movement. Dr. Kabir Hassan, Associate Professor, University of New Orleans, USA has been selected for this fellowship for his earlier experiences on the same issue. We thank him for giving us the opportunity to work with him in various stages of the study leading to its completion.
On behalf of the author, we are grateful to Dr. Momtazuddin Ahmed, Professor of Economics, Dhaka University and Dr. Toufic A. Choudhury, Professor and Director, Center for Post Graduate Studies, BIBM, Dhaka for their critical review of the study and providing valuable opinion on it. I would like to express my sincere gratitude to M. Hafizuddin Khan, Chairman, Board of Trustees, and Professor Muzaffar Ahmed, Trustee, TIB for their keen interest and support for the study. I would like to thank Iftekhar Ahmed Chaudhury, Director, Research and Policy, TIB for coordinating various activities in connection with the successful completion of the study.
We hope that the concerned authorities and other stakeholders would benefit from the study and its recommendations. We would also welcome all constructive criticisms and suggestions from anyone which would facilitate further enrichment of the study.
Iftekharuzzaman Dhaka, January 9, 2011 Executive Director, TIB
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EXECUTIVE SUMMARY
The concern in the informal, unofficial or shadow economy by the researchers and practitioners
has been increased in the past few decades. The presence and widespread findings of shadow
economies is a growing problem around the world. There have been several attempts to
efficiently define shadow economies. Previous studies, without providing a perfect explanation,
have focused mainly on measurement and general characteristics of the shadow economy, its
impact on the formal economy, and policy design addressing the sources and outcomes.
However, as of today, there exists no universal definition, but rather opinions form economists
and scholars. The most commonly used definition of shadow economy is: all currently
unregistered economic activities, which contribute to the officially calculated (or observed)
Gross National Product.
The activities of shadow economy include both legal and illegal activities that are of monetary
and non monetary in nature. Legal activities of monetary in nature may include tax evasion
(unreported income from self-employment, wages, salaries and assets accumulated from the
work related to legal services and goods) and tax avoidance (employee discounts and fringe
benefits). Non-monetary transactions may include the bartering of legal goods and services
(cause tax evasion), and all do-it-yourself work and neighbor help (by tax avoidance). Illegal
monetary activities may include drug dealing and manufacturing, trade with stolen goods,
prostitution, gambling, smuggling and fraud. Non-monetary activities may include barter of
drugs, stolen goods, smuggling, drug production for own use and theft for own use. This paper
defines shadow economy as unreported income from the production of goods and services to
avoid paying income taxes.
The relationship between corruption and shadow economy can either be complements or
substitutes. The tendency of officials in claiming a bribe is reduced by the existence of the
shadow economy as shown by the substitute model group; whereas the complement group of
models shows that labor can be either employed in the official sector or in the shadow economy.
The size of the official market reduces as the shadow economy increases.
There is however no formal analysis in Bangladesh on corruption.. The current study attempts to
estimate the size of shadow economy that exists in Bangladesh. Unlike prior studies, this study
estimates both the shadow GDP and its three components, namely the domestic sector, import
sector and export sector, thus provides insights into the dynamics of the shadow economy.
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According to the estimate of this study, during 1972 – 95, of the total formal GDP, about 22
percent was shadow GDP, whereas domestic shadow economy averaged 37 percent (Hassan,
1998). On the other hand, the size of the shadow economy in Bangladesh averaged 35.9% of
GDP over 1999-2007 as estimated by Schneider, Buehn and Montengero (2010).
STUDY OBJECTIVES The key objective of this study was to estimate the current size and then to indentify the nature
or form of the shadow economy. Specific objectives are -
– Estimate the size of the shadow economy by a currency demand approach.
– To ascertain the nature of the shadow economy in Bangladesh.
– Policy recommendations to reduce this size.
Causes of existence of shadow economy
The main causes of shadow economies are burdens of tax and social security contribution,
intensity of regulations, the inequality of income, the quality of public sector services, and
improvement in technology. More specifically the following reasons are significant causes in the
very existence of shadow economy.
Tax and Contribution to Social Security System
The driving force that pushes people to work in the shadow economy is the difference between
the large total costs of labor in the official economy in comparison to the after-tax earnings (for
work). This makes tax to be considered as an important variable. A larger distortion of the labor-
leisure decision is caused with an increase in the marginal tax rate which increases the
substitution effect (meaning that individuals can and will earn an income in the shadow
economy and work less in the official economy), as stated by the Neoclassical models.
Institutional and regulatory factors such as the extent of control by politicians and bureaucrats,
administrations efficiency, and the amount of bribery and corruption also affect the shadow
economy.
Regulatory Burden
An increase in the number of regulations and laws reduces the choices available to the firm and
employees in the official economy, leading to a rise in the labor costs. Corporations affected by
these regulations push the cost down to their employees, which is a significant reason why these
employees move from the official economy to the shadow economy.
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Income Inequality and Poverty
Those who will participate in shadow economy will have higher income, and therefore it is
evident that shadow economy increases the inequality of income. The size of the shadow
economy depends on the size of the inequality among rich and poor. The greater the inequality,
the larger is the size of the shadow economy.
Quality and Quantity of Public Services
An increase in the size of the shadow economy leads to a reduced revenue for the state, which in
turn affects the quality and quantity of the publicly provided goods and services. An incentive
for bribery and broader ineffective regulations increases in the developing countries as they face
higher tax rates. However, Johnson, Kaufmann, and Zoido-Lobaton (1998) show that in
countries with higher tax revenues, achieved through lower tax rates, fewer regulations and laws
and less bribery facing corporations, the shadow economy will be smaller in size.
Black money is global phenomena. Given the tax burden the overall value of black money in
Bangladesh is higher than that in Malaysia, Singapore, Taiwan and Thailand1. In the 2009–10
fiscal year, investments were made in the establishment of new industries, construction of
infrastructure, modernization, expansion and repairing of old industries by 1923 individuals who
whitened their undisclosed income and paid tax only Tk. 1212.95 crore2.
METHODOLOGY Following three different approaches the above objectives were tried to meet. At first we
conduct an Expert Citizens Survey in Bangladesh to understand the nature and dynamics of the
shadow economy in Bangladesh. Then we estimate the size of the shadow economy by a
currency demand approach. Finally, we estimate a quantitative approach called multiple
indicators, multiple causes (MIMIC) that explicitly considers multiple causes and multiple
indicators of the shadow economy.
a) Expert Citizens Survey:
An expert citizen survey3 was carried out to capture experts’ experiences and knowledge on the
process and measures adopted by individuals--as well as corporate entities--to hide actual
1 http://images.forbes.com/media/2006/05/misery_chart.gif 2 BDNews24.com, July 13, 2010 3 Instead of surveying general citizens to capturing the real income or earnings of the household as planned earlier, we perform an expert citizens’ survey to identify their knowledge and experiences on the process of hiding the earnings from legal and illegal sources. Based on earlier experiences, it is found that
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income to avoid or evade taxes. The survey supplemented findings on the estimated volume of
the shadow economy that was generated from the model based on the secondary information. A
structured questionnaire was used for the survey. Both five point and three points scales were fit
in the questionnaire based on the types of the questions.
The survey of 202 different experts of Dhaka, Chittagong and Khulna was taken during the
period spanning 10th June to 10th July, 2010. Of the 202 respondents, 150 were from Dhaka, 30
were from Chittagong, and 20 were from Khulna divisions. Chittagong and Khulna divisions
were included to reduce biasness in sample selection. Table 2 shows that the respondents were
either high officials of the Bangladesh Bank (Money Laundering Unit) or other commercial
banks with participation from foreign exchange divisions; Chartered Accountants, eminent tax
lawyers, higher level taxmen of the NBR and people from CIS cell, staff of multi-national
companies, Justice and senior level advocates of High Court, university professors of finance,
sociology and related subjects. Many were senior level politicians who carry credibility or CSO
that included several advisers of the Care Taker Govt. Top or senior economists, journalists
assigned to report on economic, financial and corruption issues; and staff of accounts section of
different private service providers like universities and diagnostic centers were included in the
sample.
Sample Selection
A stratified random sampling method was followed to select the respondent professionals. First,
based on the different sources, a broader list of about 600 experts of the above-mentioned
categories was prepared and a table of randomly generated number was followed to select 202
respondents. In case of unavailability of the desired person, a randomly selected next one was
chosen. In few cases--due to small population--the sample was selected based on the reference
of already surveyed expert. The overall size of such sample is less than 5 percent.
Field Operation and Validity of Data
A group of experienced graduates of different disciplines like economics, sociology and
journalism were recruited for the survey. The surveyed questionnaires were checked randomly
by supervisor and researcher. To avoid any bias, the structured questionnaire was followed and
enumerators were advised to follow the randomly selected list. Both spotchecks and back-checks
were done to ensure validity of data.
people are reluctant to disclose their real income and any projection based on those numbers will provide wrong estimates.
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(b) Methods to estimate the size of the shadow economy
The size of the shadow economy is often estimated by using the following methods: the direct
approach, indirect approach and the model approach.
The Direct Approach
The direct approach is a micro approach that involves two techniques. The first technique uses
designed surveys and samples based on voluntary replies where information is gathered in
details. The other technique involves tax auditing and multiple compliance methods. There are
two major methods to determine the size of the shadow economy under this technique. First, the
size of the shadow economy can be determined by the discrepancy between income declared for
tax purposes and that measured by selective checks. Second, fiscal tax auditing programs can be
used in determining the shadow economy. The limitations to this method includes results
normally being a lower bound as it is unable to capture all shadow activities, a fraction of the
shadow economy is captured under the tax auditing approach, sampling bias, and these methods
fail to provide indication about the growth and development of the shadow economy over a long
time period.
The Indirect Approach
The indirect approaches are mostly macroeconomic and use various economic and other
indicators, which contain information regarding the development of shadow economies over
time. Five such indicators are used:
(i) Discrepancy between national expenditures and income statistics is based on the implied
results between income and expenditure statistics. If an estimate of the expenditure
measure is available, the gap between the income measure and the estimated expenditure
measure can be used as an indicator of the size of the shadow economy. This approach can
be applied to the official and actual labor force.
(ii) A Transaction approach which states that there is a constant relationship between
official GDP and the volume of money. The size of GDP in the shadow economy can be
estimated by subtracting the nominal GDP from the official GDP (Feige, 1979). To
estimate this assumptions have to be made in regards to the relationships between the value of
total transactions (p*T) and total (official + unofficial) nominal GNP, and the velocity of money.
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(iii) Currency Demand Approach that uses a calculation of the correlation of the currency
demand and the tax pressure as one cause of the shadow economy. An increase in
currency means an increase in activities in the shadow economy.
(iv) The Electricity Consumption Method covers two different approaches. The Kaufmann–
Kaliberda method which implies that an increase in the overall electric-power
consumption means there is an increase in the activity of the official and unofficial GDP.
The difference between the gross rate of the total electricity consumption and the gross
rate of registered GDP can be attributed to the growth of the shadow economy. The other
approach is the Lacko method which involves the measurement of household
consumption of electricity, under the assumption that if the section of the shadow
economy involved with household electricity consumption is high, then the remaining
section will also be high.
c) The Model Approach
The model approach is a statistical theory that uses unobserved multiple causes and multiple
indicators of the phenomenon to be measured. To measure the hidden economy as an
unobserved variable over time, the factor-analytic approach should be used. The DYMIMIC
(dynamic multiple-indicators multiple-causes) model can also be used, which treats hidden
output as a latent variable, and uses several indicator variables and several (measurable) causal
variables. The measurement model links the unobserved variables to observed indicators. The
specification of causal relationships among the unobserved variables is done through the
structural equations.
MIMIC Model:
This model explicitly considers multiple causes and multiple indicators of the shadow economy.
Factor analytic approach is used to measure the shadow economy as an unobservable variable
over time. High taxation, heavy regulation and declining tax morality cause the growth of
shadow economy, and manifest into indicators that shows the size of shadow economy. Such
indicators are monetary statistics, labor statistics and production market indicators.
Regular surveys of household and consumer behavior may be used to find discrepancies
between the official estimation and the ones estimated in the surveys to measure the size of
unreported activities, which however may be subject to non-response biases. Economists,
therefore try to estimate the size of the SE by studying the behavior of aggregate data.
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Popular methods of estimating among academics are based on macroeconomics models of either
the demand for currency holdings or the consumption of some standard commodity such as
gasoline, or electricity. However, in recent years, there has been an increasing interest in a more
"complex method" known as the "structural equations" or "multiple indicator multiple cause"
(the MIMIC model). MIMIC has its origin in factor analysis of psychometrics but has been used
to estimate latent variables in economics models (Zellner, 1970; Goldberger, 1972). The idea is
to represent the UE as a latent variable or index, that has causes and effects that are observable
but which cannot themselves be directly measured (Breusch, 2005).
In the context of estimating UE, a MIMIC approach needs a vector of indicator variable and a
vector causal variable. The variables are connected by unobserved latent variables.
MIMIC was first applied by Frey and Weck-Hanneman (1984) to estimate the SE. The idea was
extended by Aiger, Schneider and Ghosh (1988) by allowing some lagged adjustment in a
dynamic model (DYMIMIC), which was further modified by Giles (1999) to incorporate unit
roots and cointegration analysis.
The literature on using the MIMIC approach to determine SE has shown that the estimated
coefficients are unstable with respect to change in sample size and different specifications. There
is no clear evidence that variables other than taxes are “causes” for SE, and the “causes” and
“indicators” commonly used in estimating SE are unreliable.
(A) EXPERIENCES OF THE SURVEYED EXPERT CITZIENS OVER SHADOW ECONOMY OF BANGLADESH:
Analysis and findings of the expert citizen’s survey are gathered in this section to portray the
nature of the shadow economy or a black market for money in different studies as well as in
policy notes. The marginal utility is turned down and unproductive expenditures are caused due
to the presence of black market money.
Black money and its impact on the economy as well as income inequality
Most of the respondents (74.8 percent) of the expert citizen’s survey strongly agreed on the
statement that black money is harmful for the economy of any country, while an insignificant
number of respondents (2 percent) disagreed on the statement. The Income Tax law states tax
evasion to be an offence while tax avoidance (a clever use of technicalities of law to lessen tax
burden) is not. A maximum of 25 percent tax has to be paid by an honest taxpayer on his legal
earning under the current tax system. However, a black money holder can whiten his/her
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earnings by investing in specific sectors by paying only a lighter burden of 10% tax on the
'undisclosed' money.
Figure 1: Black money increases income inequality
1.5 4.59.9
82.7
1.00
10
20
30
40
50
60
70
80
90
Strongly disagree Disagree Neither agree ordisagree
Agree Strongly agree
(In p
erce
nt)
Source: Expert Citizens Survey: June 10, 2010-July 10, 2010
Around 82.7 percent of respondents agreed that black money increases income disparities, the
finding being compatible with the growing poverty in Bangladesh as well as the growth rate of
Bangladesh. Rates of both disagreement as well as strong disagreement were equal by 2%.
Interestingly the respondents who neither agree nor disagree almost tie at 9.9 percent, which
may be due to the knowledge gap or indifference to the current state of progress of the country.
Black money, investment, production and spread of corruption
According to RRC Report (2003), “Black money deprives the country of the benefits of
productive investment and produces inflationary pressure on the economy”. The survey finds
that 26.2 percent of the respondents strongly agreed with the statement that black money
increases investment and production, while 21.3 percent only agreed to the statement.
Interestingly, 86.2 percent surveyed expert professionals claimed that black money spreads
corruption that ultimately affects the income level and increases income disparities. The same
group of surveyed professionals was also concerned about the link between the shadow
economy and spread of corruption.
Corruption and discrimination supplement each other. Corruption is anti-poor. If corruption
cannot be prevented, it must be discouraged. Around 84.2 percent have revealed that black
money or a shadow economy spread corruption in the society according to the survey, indicating
that it has significant effect on the welfare of the country.
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Figure 2: Black money spreads corruption
4%1% 1.5% 7.4%
84.2%
1.5% 0.5%
Strongly disagree Neither agree ordisagree
Strongly agree Do not know
Black money and a country’s well-being
According to the RRC (2003) report, “black money has the serious potential of damaging
national security and engendering terrorist activities”. This observation is also substantiated by
the expert survey findings, where 74.8 percent of experienced professionals strongly agreed with
the statement that black money is harmful for the country since it accentuates income disparities
and macro-economic instability. Moreover, 50.5 percent of the experts also opined that black
money has a harmful impact on the whole development process of a developing country like
Bangladesh. Interestingly, around 19 percent of respondents expressed the view that black
money is not harmful to the country.
Scope of whitening the black money
The right to a corruption-free society is a fundamental right and cannot be discarded easily since
it 'for the good of the greatest number, even for the greatest good of all' (Rajkumar, 2002). The
corrupt tycoons always wish the government will turn a blind eye on black money. After a
period of time, they will pursue permit by some influential means. Every government for the last
several years has given the opportunity of whitening black money with the condition of
investing them in productive economic activities. Among the surveyed professionals, 48.5
percent have claimed that Government should permanently stop the scope of whitening of the
black money. However, about 17 percent were in favor of increasing or maintaining the scope of
whitening the black money.
Measures or forms of maintaining shadow economy or black money
Maintaining shadow or black money is an innovation-like matter. Several forms of hiding
income and avoiding taxes have been identified through expert survey. According to the survey
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findings, a major proportion of the respondents, 67.8 percent, fully agreed that the practices of
concealing real income create the scope for tax evasion, while 23.8 percent of responses
revealed that this practice is in some cases correct. 61 percent of professional (including existing
and retired government official) fully agreed that government employees conceal their illegal
income and transfer their income through money laundering to tax heaven countries or countries
in the account of relatives or friends.
A staggering 59.4 percent of respondents fully agreed with the fact that illegal earnings are
invested in the capital market and businesses to enjoy tax exemption. Another 58.4 percent also
shared the practices of not disclosing all bank accounts in income tax return forms. Other forms
of hiding illegal income are buying plots, flats, bonds, share certificates and cars in the name of
a family member, close relative and friends who have no tax obligations by 57.9 percent of the
respondents. Also, 57.4 percent report higher amounts of original investment expenses to evade
taxes and/or report a portion of income spent as tax exempted expenses. Despite the
identification of such practices as illegal or harmful, around 25 to 37 percent respondents
acknowledged that those cases are correct in some instances. This reveals that more than 50
percent of respondents strongly identified with resorting to bad practices, albeit not on regular
basis.
Nature and practice of tax avoidance and evasion in corporate sectors
Survey result shows that the highest 77.7 percent professionals fully agreed with the cases of
showing less profit/loss in the business is key process of hiding actual income or tax evasion.
More than 50 percent respondents claimed of the cases of concealing real income thru showing
extra costs & maintaining different account book; money receipt & expense book, higher price
of the product; showing less sales price, showing taxable income as investment in tax free
sectors or as development expense, , taking loan by owners of bank & insurance companies in
the name of others, high operational cost; to hide their actual income and evading taxes as well.
Other illegal measures include money laundering through import of capital machineries in high
price, sale of product imported under custom bond in local market illegally, not using for
exportable thru non-transparent/manual account keeping and preparing fake audit report.
Tax avoidance and/or evasion by professionals
The survey reveals that more than 60 percent of the respondent fully agreed with the prevalence
of showing fewer clients during inspection or audit of tax officer, showing commissions to
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doctors as test cost, tax evasion through loophole of law & help from tax officers, money
laundering through bank draft (Hundi), keeping different account book/file for tax & business.
More than 50 percent professionals also fully agreed with other forms of veiling actual income
through laundering foreign aid in the name of fake project by some NGOs, money transaction
without receipt between service taker and service provider, showing less remuneration-fee in the
contract with consultant, concealing the illegal money earn from extortion in the name of
transport labor-owner association.
b) ESTIMATION OF SHADOW ECONOMY: A CURRENCY DEMAND MODEL
The currency demand approach has been widely used to measure the size of the Shadow
economy. Cagan (1958), analyzed the demand for currency specifying expected real income,
expected interest rates, and tax rates as explanatory variables. Tanzi (1980, 1983) modified
Cagan’s approach by estimating a currency demand function for the United States for 1930-
1980. The approach to measure the shadow economy consists of specifying a demand-for-
currency equation to infer the effect of a change in the tax level on that demand with the key
assumptions that (i) the Shadow economy activities are the direct consequence of high taxes and,
(ii) the transactions are made using mainly currency. The current study uses the Tanzi (1980,
1983) model with some modifications to fit in the Bangladesh economy.
We estimate dynamic error-correction-based currency demand model, which appropriately
adjusts the non-stationarity of time-series data with unit roots (Klovland 1984; Faal, 2003). The
independent variables are domestic taxes proxied by the ratio of all domestic taxes (local and
income taxes) to domestically consumed and produced income (Gross domestic product minus
export), real interest rate, level of banking service proxied by domestic credit provided by
banking sector to gross domestic product (GDP) and real GDP per capita as a proxy for
economic development. All data have been gathered from Word Development Indicators (WDI)
database for the period 1974-2008.
The independent variable (C) is real currency at time t, whereas the explanatory variables are as
follow:
T: domestic taxes: tax burden has a positive effect on currency demand. An increase in taxes
raises the relative prices of taxable versus non-taxable activities. A rise in tax should increase the
non-taxable (shadow) activities. The domestic tax is proxied by the ratio of all domestic taxes
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(local and income taxes) to domestically consumed and produced income (Gross domestic
product minus export).
R: real interest rate: A higher real interest rate should increase the opportunity cost of holding
currency and therefore a decline in currency demand.
BNK: Level of banking service: Improvement in banking service should decrease demand for
currency since people will use banks for making business transactions. Banking service is
proxied by domestic credit provided by banking sector to gross domestic product (GDP).
GDPPC: real GDP per capita: real GDP per capita proxies for economic development. A higher
level of economic development should lead to a decrease in demand currency if demand for
deposit increase. However, it is unclear whether in developing countries demand for deposit
increase when GDP per capita increases because the level of GDP per capita is usually low and
other factors (such as cultural factor) may influence the decision of holding currency or not. An
increase in taxes raises the relative prices of taxable versus non-taxable activities, and therefore
we expect non-taxable (shadow) activities with at rise in the tax. The opportunity cost of holding
money rises due to higher real interest rate, which decreases the currency demand. Improvement
in banking service is expected to decrease the demand for currency since people will use banks
more for making business transactions. It is expected that a higher level of economic
development should lead to a decrease in demand currency if demand for deposit increase.
Regression Result All data comes from Word Development Indicators (WDI) database for the period 1974-2008.
The regression results are (robust standard t statistics in parenthesis):
(3.28) (0.72) (0.20) (1.67) (2.41) (2.43) (-3.28)
Durbin-Watson = 2.04 Adjusted R-squared = 0.73
Level of taxes in a previous period is significantly positively related to change in currencies.
Although not significant, an increase in taxes results in an increase in demand for currency. As
expected, a significant association has been found between bank service and per capita GDP
with currency demand. A marginal increase in the economic development leads to an increase in
currency demand. Since the economy is growing and people are accustomed to use cash in their
transaction, people demand more cash transactions to perform their business.
We use the estimated result of the regression to estimate the shadow economy (UE). At first we
use the regression to estimate the currency demand, and then we estimate the demand for
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currency if there were no taxes by setting the coefficients for taxes equal to zero. The difference
between the two estimates is the illegal money. Since income velocity of money in the
underground economy is unobservable, we assume that it is same as the one from legal money.
The highest peak of UE in Bangladesh was at the end of 1970s, when the size of the UE was
almost 20 percent of GDP, which decreased to a long run average of 10 percent. The UE size in
Bangladesh averaged 10.1 percent since the 1980s, and thus it has been stable for the past 20
years.
Shadow Economy and Banking Sector Development
We run regressions of the UE on some banking development indicators. We focus on some
indicators from the WDI database and financial database4 to capture banking development. We
also construct an index of bank development following a methodology proposed by Calomiris
and Beim (2001). A financial depth index using domestic credit to private sector, domestic
credit provided by banking sector, and liquid liabilities, all as percentage of GDP is created at
first. Then we calculate an inefficiency index based on bank overhead costs, net interest margin,
lending-deposit rate spread, and value of central bank assets as percentage of both central and
private bank assets. Finally, to capture the overall quality of a banking system, we create a
composite index using depth index and inefficiency index (Bose et. al, 2010). Two separate
estimates were done, where Panel A uses sample period 1995–2008 and Panel B uses a sample
period 1975–2008.
Results from Panel A show that political stability is significant and negatively related to UE,
which means that in periods of political stability the Bangladeshi people use less UE activities. It
is also identified that higher control of corruption leads to more use of UE. Results also show
that higher banking development leads to a significantly lower use of UE. Higher concentration
of banking system is negatively associated with UE and higher ROE is positively associated
with UE. From Panel B, we find that the level of deposit money bank to total deposit in the
system is negatively related to UE size. Thus, banking development is associated with less
shadow activities.
THE SIZE OF THE SHADOW ECONOMY: A MIMIC APPROACH
A MIMIC method used by Schneider, Buehn and Montenegro (2010) was followed to estimate
the size of Shadow economy for a number of Asian countries. Our results are very similar with
slight variation. For example, for Bangladesh our results vary from 39.2 to 38.1 during 1996-
4 The data base were compiled by Beck, Demirgüç-Kunt and Levine (2000, 2006, henceforth, BDL)
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2008 whereas Schneider et. al (2010) finds the size of UE in Bangladesh is 35.9 % over 1999-
2007.
The results estimated show that non-policy “economic” causal variables, such as the level of
development and the state of the economy measured by the GDP per capita, inflation and the
unemployment rate, are very important determinants of the shadow economy. The estimated
coefficients indicate that an improvement of economic conditions would reduce the size of the
shadow economy. The impact of “policy” causal variables, such as trade openness is important
determinant of shadow economy. According to model specification, a one percent reduction in
the size of government, the proxy for the burden of indirect taxation, would, on average reduce
the shadow economy by 0.20 percent in the group of countries analyzed in this research.
Table 1: Results of the estimated Model Model 1 Model 2 Causal variables
Size of Government 0.331*** (0.080)
0.203*** (0.093)
Fiscal Freedom -0.017 (-0.024)
Direct taxes 0.015 (0.015)
Unemployment 0.921*** (0.193)
0.608*** (0.257)
GDP per capita -0.035* (-0.019)
-0.001 (-0.016)
Inflation 0.050*** (0.017)
0.037 (0.029)
Trade Openness -0.005 (-0.003)
-0.008*** (-0.004)
Indicator variables
GDP per capita Growth -0.106** (-0.043)
-0.302*** (-0.152)
Labor participation -1.435*** (-0.281)
-2.190*** (-0.930)
Currency 1.000 1.000 Statistics test RMSEA (p-value) 0.0831 (0.03) 0.1172 (0.00) Chi squared 38.28 (0.00) 142.0 (0.00) Degree of freedom 12 12 Number of observations 351 250
The MIMIC result reveals that the size of the shadow economy ranges from 29 percent in 1996
to 46.6 percent in 2004. It also observes a downward trend of the shadow economy, declining
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form 36.6 percent in 2006 to 34.4 percent in 2008 and the average size of the shadow economy
for the period from 1996 – 2008 is 38.1 percent. We combine the results from currency demand
model and MIMIC models (though not statistically valid) and conclude that the size of the
shadow economy in Bangladesh is approximately 24 percent of the formal GDP.
CONCLUSION AND POLICY RECOMMENDATION
Estimating the size of shadow economy in any country is a daunting task. We attempt to give a
picture of shadow economy perception and estimates in Bangladesh economy using one survey
and two model based techniques. We find that the size of the SE in Bangladesh is 10 percent
according to the currency demand approach, and 38 percent according to MIMIC approach.
Economic variables were also found to be more important than policy variables in the shadow
economy sector.
The four main driving forces of the shadow economy identified by the current paper are: overall
tax – both direct and indirect, and social security contribution burdens, intensity of regulations,
public sector services, and the state of the “official” economy. Causal variables of the shadow
economy can be divided into two categories: economic variables and policy variables.
Economic variables describe a country’s level of development and the state of its economy and
include things such as GDP per capita and the unemployment rate. Policy variables include
regulations and various measures of the tax burden. When examining the results, we find that
economic variables generally influence the size of shadow economies more than policy ones.
We conclude that if governments can implement incentive-oriented policy measures that make
work in the shadow economy less attractive, this may lead to a stabilization, or even reduction,
in the size of the shadow economy. While economic conditions such as per capita GDP cannot
be changed at will of the governments, implementing economy-oriented policies will induce, or
increase the incentive for, certain behaviors, such as keeping one’s money in the official
economy. The best policy measure governments can take to reduce the size of the shadow
economy is to reduce the tax burden. With lower taxes, there is less of an economic incentive to
skirt those taxes and do business in the shadow economy or abroad. The next best option for
reducing the underground economy’s size would be lessening fiscal and business regulations, a
policy with direct economic benefits for businesses that choose to operate in the official
economy.
Increased regulations alone will not solve the problem of the growing shadow
economy. Regulations, in fact, are shown to spur its growth. But excessive regulations and
restrictions will only push more and more people into the shadow economy, thereby depriving
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the government of more and more tax revenue and infringing on the rights of those who must
seek employment in the shadow economy, where working conditions may be dismal and
minimum wage just a myth (Davidson, 2010).
Increased financial transparency will help reduce the size of the shadow economy. It becomes
more difficult to conduct illegal financial activities when the transfer, banking and reporting
processes are more transparent and globally accessible. If people cannot hide their money, then
they cannot use it in unrecorded exchanges without arousing suspicion. If all income is
recorded, then none of it can skirt income taxes. Underground economies can no longer remain
in the shadows when the financial activities that drive them are brought into the light and
rendered transparent (Davidson, 2010).
Given the current per capita income, Bangladesh should be collecting at least 12-13 percent of
GDP as tax revenues; however, tax revenue as a share of GDP is a meager 9 percent. Tax system
should be transparent so that informed tax payers understand how taxes are assessed and be
simple enough for most tax payers to have the option to do their own filing. More complex cases
can be handled by tax accountants and tax lawyers (Ahmed, 2007).
Another powerful characteristic of a good tax system is voluntary compliance with self
assessment. This is only achievable in the light of transparency and simplicity of the tax system.
This has the powerful incentive that it eliminates any kind of tax fraud or avoidance through
collusion with the tax official. The system cuts through this aspect of corruption directly at the
source, a predominant feature in the corruption-ridden environment of Bangladesh (Ahmed,
2007).
Another facet of a proper tax system is selective audit, which ensures self assessment to be
accurate and voluntary compliance in line with tax laws. The tax authority should be
autonomous and adequately empowered to carry out their duties without undue political
influence. The tax authority must be adequately staffed with seasoned professional personnel
with requisite expertise.
The tax laws in Bangladesh should be simplified to file income tax through a one page form
(such as the one used by USA citizens). As a top priority, a safe distant relationship between the
tax payer and the authority should be established. A system of rigorous audits must be
established with the full force of law without exception.
We provide a number of policy measures below. We emphasize that good governance on the
part of tax administration and pragmatic policy formulation on the part of the Government are
keys to reduce the size of shadow economy in Bangladesh. We offer this list of implications for
policymakers as put forth by Schneider and Enste (2002):
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a. Even major reductions in tax rates will not substantially shrink the shadow economy but
reductions may be able to stabilize it;
b. Marginal tax rates are more relevant to people's shadow-economy work decisions than
are average tax rates so replacing direct taxes with indirect taxes is unlikely to improve
tax compliance;
c. More frequent tax audits and heavier penalties for tax evasion may reduce the size of the
shadow economy;
d. Governments should put more emphasis on legalizing certain shadow economy activities
(i.e. liberalizing the labor market);
e. Reforms that liberalize regulations and make the economy more competitive reduce the
incentives for corruption, and encourage firms to move from the shadow economy into
the official one;
f. Governments should emphasize the rule of law by strictly enforcing a minimum
necessary set of regulations in place of simply increasing the number of regulations.
Specifically, we provide the following policy suggestions to combat the spread of black
economy in Bangladesh:
1. The policymakers should ensure the complete withdrawal of the provision of whitening
black money and seal the source points through effective automation among central
bank, banks/financial institutions and the NBR.
2. The law should be framed to crucify the black money holders and patronages with
exemplary punishment (both financial and other type).
3. Each policymaker should be legally obliged to submit their financial statement and asset
holdings in regular interval to the ACC.
4. Independence of both the ACC and the NBR to trace the black money and black money
holders should be ensured.
5. Political patronization to black money holders should be made a punishable offence, and
this may be regulated by the CAG, EC and ACC.
6. Adequate changes in the tax and business related system should be reformed soon to
make the business environment hassle-free and more investment-friendly.
7. Adequate research and resources should be mobilized to identify the dubious source of
financing and process of black money formation.
8. All commercial transactions, beyond a fixed limit, should be made through banking
channels.
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9. Intensive research and analysis is required to identify the impact of tax incentive and
incidence of existing corporate tax incentives in terms of equity and reduction of creation
of black money.
10. Legal reform should be ensured to ensure the highest level of transparency and
accountability of tax officials & staff.
11. Strict enforcement of the law against tax evasion including rigorous financial sanctions
should be implemented.